repeat managerial economics

7/31/2019 Repeat Managerial Economics

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Capital budgeting

2.3 Financing Methods and their Role in a Project

Project Financing Management (PFM) is considered as one of the most important processes for aproject success. In this process, the project manager considers the financial information andresources to make a decision. This enables the project manager to get results on time and withinthe budget. The finance management plays a role not only for the borrower, but also for thelender.

Projects must be financially, economically, socially, and environmentally sound. The PFM helpsin this by identifying and preparing a suitable structure of the project. This is to ensure goodarrangements, so that the lender can determine whether the conditions are good enough for theproject to succeed. For example, if a number of companies require a loan from the World Bank,

it will work as explained above.

Project Finance (PF) is an important subject in the enterprise financial environment. Nowadays,it has been used with effectiveness and notable success and as an alternative to finance an amplerange of projects. What distinguishes the financing project management from the customarydirect financing is that, instead of using all the assets of the company to generate cash flow,financing project management uses financial engineering. This is to get an advantage of theresources that are available and to manage them to achieve successful arrangements. Financingthe project also gives an added advantage.

PF differs from traditional non-project loans, as the former emphasises on the cash flow analysis

and is referred to as Cash Flow Finance. The main concept is that the financing agency choosesa specific plan or business entity to provide financing. The payment of principal and interest isexclusively obtained from the profit or the cash flow generated by that plan or business entity.With regard to the collateral, it is limited to the asset purchased under that specified project. Thekey issue is that banks do not allow having recourse to the project sponsor, shareholders ofbusiness entity, or the affiliated company, when the borrowers fail to honour their debts(principal and interest). Banks strongly emphasise the mechanism of financial risk-taking andproject risk sharing, due to the lack of recourse or limited recourse in project finance.

The government has released draft guidelines on the viability of gap funding for public-privatepartnerships in critical infrastructure projects. Under the guidelines, the centre proposed toprovide state governments and their agencies viability gap funding of up to 20% of the total cost,in such projects.

Lead financial institutions will be responsible for regular monitoring and periodic evaluation ofproject compliance with agreed milestones and performance levels. When it is due, they releaseviability gap funding support and obtain reimbursement from the Department of EconomicAffairs.


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According to the guidelines, the project must be constructed, maintained and operated during theproject term, by an entity with at least 40% private equity. Besides, the projects should be vettedand endorsed by the Union Ministries concerned.

Banks and financial institutions finance technically feasible, financially viable, and bankable

projects undertaken by both public and private sector undertakings. However, there are someconditions it should subject itself to. They are:

The sanctioned amount must be within the overall ceiling of the prudential exposure norms.These norms are prescribed by Reserve Bank of India (RBI) for infrastructure financing.

Banks or financial institutions must have the required expertise for appraising technicalfeasibility, financial viability, and the bank ability of projects. This is in reference to the riskanalysis and sensitivity analysis.

In respect to infrastructure projects where financing is done by term loans or investment in

bonds, issued by government owned entities. Banks or financial institutions must undertake duediligence on the viability and bank ability of such projects. This enables them to ensure efficientutilisation of resources and creditworthiness of financed projects.

Banks also lend Special Purpose Vehicles (SPVs) to the private sector, registered under the

Companies Act. This is done by directly undertaking infrastructure projects that are financiallyviable. Banks also ensure that the bankruptcy or financial difficulties of the parent sponsorshould not affect the financial health of the SPV.

2.3.1 Relaxation in Ceiling

Ceiling is the highest price or any other statistical factor which is permissible in a financial deal.It is also regarded as the maximum rate of interest that is charged in a treaty or in an agreement.In simple words, if the general rate of interest rises higher than the rate of interest on your loan,the rate which you pay cannot be increased more than the ceiling. With regard to some loans, thelenders can raise interest if they are not authorised to charge due to the ceiling to the amount. Itmeans that you will not be able to avoid the impacts of rising rates despite ceiling. Ceiling canalso be considered a cap on the interest amount an issuer of a bond will be paying. It can also bethe highest price that a contract reaches on a single day before the closing of the market.

The borrowers can have a relaxation in ceiling due to several options. Some of them are:

Credit exposure limits: Credit exposure to borrowers of a group may exceed the exposurenorm of 40% of the banks capital funds by an additional 10% (i.e. up to 50%).This happens,when the additional credit exposure is on account of extension of credit to infrastructure projects.Credit disclosure to a single borrower may exceed the exposure norm of 15% of the banks

capital funds by an additional 5% (i.e. up to 20%).This occurs when the additional creditexposure is on account of infrastructure projects. Credit exposure also includes investmentexposure.


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Risk weight for capital adequacy purposes: The bank assigns concessional risk weight of 50%for capital adequacy purposes. This is given on investment in securitised paper pertaining toinfrastructure facility. This is also subject to compliance with certain conditions.

Asset-liability management: The long-term financing of infrastructure projects result in asset-

liability mismatches. It happens particularly when such financing is not in compliance with thematurity profile of a banks liabilities. Banks need to exercise due vigilance on their asset-liability position, to ensure that they do not run into liquidity mismatches on account of lendingto such projects.

Take-out financing or liquidity support: Take-out financing structure is basically amechanism intended to enable banks to avoid asset-liability maturity mismatches. Under thearrangement, those banks financing the infrastructure projects will have an arrangement withInfrastructure Development Finance Company(IDFC) or any other financial institutions, fortransferring the outstanding in their books to the latter, on a predetermined basis. InfrastructureDevelopment Finance Company and State Bank of India (SBI) have developed different take-out

financing structures to suit the requirements of various banks. They address issues such asliquidity, asset-liability, mismatches and limited availability of project appraisal skills.

Assets Classification of Projects: A time overrun equal to 50% of the time slender ispermitted for downgrading the asset to sub-standard category. You can re-fix the timeline of theproject once the Finance board allows. This can be done even if the overrun time is greater thanfifty percent. In such a situation, the asset could be treated as standard, until the time so re-fixedby the Board. The projects under execution are classified into three categories for the purpose ofdetermining the date when the project ought to be completed. They are:

Category I: Projects in which financial closure have been achieved and formally documented.

Category II: Projects with original project cost of Rs.100 crore or more.

Category: III: Projects with original project cost of less than Rs.100 crore.

For each of the three categories, the date of completion of the project and the classification of theunderlying loan asset has to be determined.

Guarantee: With respect to infrastructure projects, banks would be permitted to issueguarantees favouring other lending institutions. This is allowed, provided the bank which issuesthe guarantee, takes a funded share in the project at least to the extent of 5% of the project cost.

They undertake a normal credit appraisal, monitor and follow up the project.

Self Assessment Questions

6. According to draft guidelines, the central government proposed to provide ____________viability gap of 20 percent to the state governments and their agencies.

7. Banks lend ____________ for undertaking the infrastructure projects


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2.4 Evaluation and Funding of Projects

There are four financial measures that decision makers expect to know in a business case basedon a cash flow analysis. How to interpret those results (including simple thumb rules), calculateeach measure, take examples of each measure, and finally assess the pros and cons of eachapproach is done as per the following criteria:

Net Present Value of Cash Flows / NPV of Cash Flows

Internal Rate of Return / IRR

Profitability Index

2.4.1 Net Present Value of Cash Flow

Perhaps the mostly widely used technique for analysing a potential investment opportunity orproject is the net present value of cash flow or NPV approach. With the NPV of cash flowtechnique, we can discount all cash flows in our business case at the opportunity cost of capital.In most of the cases, this is the weighted average cost of capital for a company. In this analysis,the rule of business which is implemented is to accept the projects and assets when the NPV ofcash flow is more than zero.

[3]Calculating Net Present Values

Many new spreadsheet applications such as Excel allow us to calculate the net present valueautomatically. For performing the calculations, you need to know the discount rate and the rangeof cash flow values.

The Excel function simply applies the following rule which calculates the present value of eachcash flow in each year.

PV = Cash Flow / (1 + r) n

Where r = discount rate, and n = the period.

The key point at this juncture is that the rate and the period have to be for the same measure oftime. So, if we are looking at annual cash flows, the discount rate has to be an annual rate. If weare looking at monthly cash flows, then the discount rate has to be stated on a per month basis.

For example, let us see how this calculation works using an example. Table 2.1 shows anexample of net present value. We have an initial investment of Rs1, 000 and three years ofpositive cash flow at Rs 500 per year and our discount rate is 8.95%.
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Table 2.1: Example of Net present value

In this example, the convention is to state results in terms of the current year or Y0 in thisexample. So by applying the formula, we figure out the present values of each cash flow:

PV Y1 = 500 / (1 + 0.0895) = 459

PV Y2 = 500 / (1 + 0.0895)2 = 421

PV Y3 = 500 / (1 + 0.0895)3 = 387

So our result for this example would be:

NPV = -1,000 + 459 + 421 + 387 = 267

And based on the NPV rule mentioned earlier, we would accept this as being a good projectbecause the NPV of cash flows is greater than zero.

Pros and Cons of NPV

The strength of calculating NPV is in recognising the value of a rupee today than the value of arupee received a year later. The other strength of this measure is that, it recognises the riskassociated with future cash flow. Another constraint of the NPV approach is that the modelassumes that capital is abundant. If resources are scarce, the analyst has to look carefully at not

just the NPV for each project which they evaluate, but also the size of the investment itself.

2.4.2 Internal Rate of Return

The Internal Rate of Return (IRR) or discounted cash flow rate of return, offer the analysts a wayto quantify the rate of return provided by the investment. The rule of capital budgeting orevaluation of the project is to accept all investments where, the IRR is greater than theopportunity cost of capital. In many conditions, the cost of capital is equal to the weighedaverage cost of capital (WACC).

Calculating IRR

The definition of IRR is the discount rate where, the NPV of cash flows is equivalent to zero.The measurement of IRR is done with the help of trial and error method. In earlier days", therewere hand calculators such as the famous HP 12C that could perform this calculationautomatically. Todays spreadsheet applications such as Microsofts Excel or Open Office

Calculation can perform this via built-in functions. For example, if you put 10,000 to purchase anew machine and get a benefit of 25,000 the next year, the IRR would be 150 %.
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Pros and Cons of Using IRR

Undoubtedly the IRR is an extremely important measure, when it comes to evaluating thefinancial flows of money for a project. Its strength consists of the wide-scale acceptance of themeasure in the financial community. It is also based on discounted cash flows so that it

recognises the time value of money. When used correctly, the measure offers outstandingguidance on a projects value. However, there are three distinguished pitfalls of using IRR thatare worth discussing. They are:

Multiple rates of return: If you are evaluating a project that has multiple changes for the cashflow stream, then, the project may have multiple IRRs or no IRR at all.

Changes in discount rates: The IRR rule accepts projects where, the IRR is greater than theopportunity cost of capital or WACC. However, if this discount rate changes each year, then, it isimpossible to make this comparison.

IRRs do not add up: One of the advantages of NPV method is that, if you want to add anadditional project to the present object, you can sum the NPVs collectively to do an evaluation ofthe project. You cannot add IRRs together. In that case, the projects should be evaluated orcombined on increment.

2.4.3 Analysing Profitability Index

The profitability index, also known as the benefit-cost ratio, is another measure that uses asimple rule to evaluate cash flow results for a given project. In this case, the profitability indexrule tells managers and executives to accept all projects that have an index value equal to orgreater than 1.

Calculating Profitability Index

The calculation of profitability index is founded on a simple relationship between a projects cost

and the discounted one after it produces tax cash flow. The formula for profitability index is asfollows:

Profitability Index = Present Value of Cash Flows / Cost of Project

So, the thumb rule for profitability index states that, we accept all projects that produce benefits(present value) that exceed the projects cost.

We use the following discounted cash flows to illustrate how profitability index is calculated. Anexample of profitability index is shown in table 2.2.

Table 2.2: Example of profitability index


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Based on the above information we know:

Present Value of cash flows = 459 + 421 + 387 = 1,267

Cost of project = 1,000

So, the profitability index in this example would be, 1,267 divided by 1,000 or 1.267 which isgreater than one. Therefore, we accept this as a good project.

Pros and Cons of Profitability Index

One of the advantages of profitability index is that it gives same effect as the one which is

provided by Net Present Value Method. When the NPV of cash flow becomes positive, theprofitability index will be more than one.


Choose the correct answer

8. ________ is used to analyse the potential investment opportunity.

a) NPV

b) PV

c) IRR

d) ROI

9. PV is calculated using the formula_____________.

a) Cash flow/ (1+r)n

b) IRR/(1+r)n

c) ROI/ (1+r)n

d) Cash flow/(1-r)n

10. PV of cash flow or cost of project is ____________.

a) PV/NPV


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b) Cost of project/ PV of cash flows

c) NPV/IRR

d) PV/NPV

11. If your initial investment in a firm is 10,000 and 1000, 1500,2500,3500 and 40000 are theinitial cash flows for 5 years, the NPV for 5 years is:

a) 3500

b) 5000

c) 1000

d) 1500

2.5 Evaluation of Cash Flows in the Project

The methods for evaluating the opportunity of an investment project are the NPV method and theIRR method. The project is profitable, if the NPV of the project is greater than zero or the IRR isgreater than some minimum predetermined rate. Thus it should be undertaken. The initial step inthis analysis is to calculate the cash flow, and the discounted cash flow (with the previous yearscash flow (up to and including the current year). It shows how much money is still invested ortied in the project at this time with appropriate signs) generated by the project. Based on them,we calculate the following:

The percentage of the discounted cash flows in the initial investment: Generally, theinvestment or the preliminary cost occurs in the first year(s) of the project and is registered as anegative cash flow. If the investment is stretched over several years, the initial investment isconsidered to be the sum of all these yearly expenditures or the sum of all discountedexpenditures (which is the PV in the first year of all investments to be made for the project).

The percentage of every cash flow in the early investment tells us how much we invest or howmuch we recover from our total investment every year, during the economic life of the project.

If the initial asset is taken in absolute value and each cash flow is shown with suitable signs, thepercent of discount cash flows become negative for years when the project needs investment.

The accumulated percentage of the discounted cash flows in the initial investment: Foreach year, it is simply the sum of the percentages calculated for the previous years and thecoming years. It roughly shows how deep we are into debt. An accumulated percentage of -100%will be obtained for the year when the investment is complete. This is when, the debt is thedeepest. After this year, we start recovering some part of the investment every year, and theaccumulated percentage will show the amount still to be recovered from the investment. The


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accumulated percentage for the previous year will equal the percentage of the PV of the project(i.e. the amount of all discounted cash flows) in the initial expenditures or investment.

Cash Balances: These are the sum of all cash flows already realised at any given point of time(considered with the appropriate signs). For every year initially, the cash balance are negative for

most projects, as they start with expenditures (investments). The maximum (negative) cashbalance in absolute value when obtained must be noted. This number shows the maximumamount of investment that is tied in the project. Even though the project is on profits, one willnot be able to get this maximum balance of cash at a time when it happens and when one will notbe able to take the project.

As the project starts generating revenues, cash flows become positive and the negative cashbalances decrease in magnitude. However, if they are still negative for a while (as long asrevenues generated by the project do not exceed the investment), the decrease in the absolutevalue of cash balances simply shows that the investor starts to recover part of the investmentmade.

A second important point to note is when we obtain the first positive cash balance this moment iscalled the payback period. This period represents the period of time required to recover all theinitial investment and obtain the first revenue of profit.

The total of all balance cash at the end of the project will be equivalent to the total of the cashflows that are not discounted. The issue with regard to balance cash is that they do not considerthe interest which should be paid for an amount purchased from the bank or the interest amountgot on a particular amount in the bank. Actually, the balance cash that is carried to the initialyears is equal to liability. If these cash balances turn positive, they are equal to the amount in thebanking organisation and to the earned interest. Thus, a better calculation of the tied cash in the

project is given by the cash balances.

The Interest Based Cash Balance (IBCB): The IBCB for the present period is acquired byadding the current (undiscounted) cash flow to the IBCB carried from the previous period andthe interest that applies to it (the formula doesnt work with subscripts). Like cash balances,

IBCBs for the project are negative for the initial years (due to investments or outflows) and

become positive as the project generates enough revenue to recover the costs. The interest basedpayback period (or discounted payback period) is where the projects inflows exceed the project

outflows, considering the interest, or the moment when we obtain the first positive IBCB. It isusually larger than the payback period. The cause for this is that we require time to recover notonly the initial investments or expenditures, but also the interest that applies to them. The lastIBCB gained for the project will be the same as the future value of the project in the final year(the accumulated sum of all cash flows compounded with the appropriate interest rate).

The Profitability Index PI (The Cost-benefit Ratio): This ratio determines the PV of allinflows (benefits) to the PV of all outflows (costs). A project is profitable once its NPV ispositive. Thus the PV of benefits is higher than the PV of costs. The project must be acceptedwhen the profitability index is greater than 1. It is not profitable when the index is less than 1.


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Main Financing Instruments

In the previous section, we have discussed about the evaluation of cash flows. Now, let us learnabout financial instruments. Financial instrument is any agreement that give rise to one monetaryasset of one entity and a financial and legal responsibility of another entity. Financial instruments

are regarded as tradeable parcel of capital each having their own features and composition. Theclassification of financial instruments is one of the main stages in monetary statistics. In thepresent financial scenario, financial instrument can be classified as equity based and loan based.

There are several prominent financing instruments. They are:

Factoring

Forfeiting

Leasing

Factoring: Factoring is the sale of accounts which is done directly and is receivable to a firmknown as a Factoring House. In other words, the liability of the client is obtained by the thirdparty who undertakes the risk and the responsibility of payment collection. This mediator will bea bank or a firm owned by someone. They will charges an amount for undertaking the risks andinterest. In factoring, the exporter makes sure that payment is collected for exports and makes areduction on the risks.

Forfeiting: Forfeiting is the buying and selling of commercial credits such as bills of exchange,promissory notes, and other negotiable instruments with medium-term maturities. The financialorganisation provides funds to the exporter and gives guarantee regarding the reimbursement of

the transaction money and agree to the condition that he will not demand a remedy against theexporting person if he makes default. In this, the advantages are in plenty for exporter. There is acomplete reduction of political, commercial and other risks. The banks also are devoid of risks asthey have the coverage of Spanish Company for Export Credit Insurance (CESCE) FloatingPolicy for Forfeiting.

Leasing: Leasing is a long-term financial method in which a bank obtains a product and givesit as lease to the importer. Once the contract ends, the importer returns the product back or isopen to the option of buying it for an amount which is agreed previously. This technique is usedfor buying machines, vehicles, plants and turnkey facilities. As per this agreement, the bankobtains the commodity in its name and receives a monthly amount from the importer.

Foreign Exchange Credit Policy

When the company has a range of payments and receipts in foreign currencies, it may see itsuitable for this type of policy. This allows the company to access credit and collects paymentsin the specified currencies. The major advantage is that the foreign exchange risk is condensed,currency flow is easily administered, the need to change money is reduced, and multipletransactions are financed simultaneously.


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Venture Capital Companies

Another alternative for financing is by means of venture-capital institutions. These are publiclimited companies specialised in purchasing temporary equity in non-financial companies, whichare not listed on the stock exchange. Venture-capital firms can function by yielding loans or by

other forms of long-term financing. They also provide advisory services.

[4]


Choose the correct answer

12. _________ is the method used in evaluating the project opportunity.

a) NPV

b) IRR

c) IBCB

d) PV

13. Identify the correct statement with respect to factoring:

a) Financing instrument and is a process where direct sale of accounts is receivable to an

organisation and the debt of the customer is acquired by the third party.

b) Process where the tasks are performed by a non banking organisation.

c) Process in which no fee is charged.

d) Process in which the exporter make sure the collection of payments for its exports andincreases risks.

2.6 Summary

In this unit, we have discussed the concept of capital budgeting process. Budgeting for a projectis essentially an important and tedious task. It can be made simple by aligning it with the firmsobjectives. One can adapt methods like NPV to develop an effective budget.

Investment projects can be classified into three categories on the basis, of how they influence theinvestment decision process. The capital budgeting process involves various steps/phases.
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When managing the financial aspect of a project, the project manager is creating a process whichbrings together planning, budgeting, accounting, financial reporting, internal controlling,auditing, and the physical performance of the project. This is done with the aim of managing theproject resources properly, in order to achieve the projects objectives. The evaluation of funding

of projects is done with NPV or Net Present Value of cash flow.

2.7 Terminal Questions

1. Define the capital budgeting process.

2. Explain the quantitative factors in project evaluation.

3. Describe the different classification of asset categories.

4. Explain the different evaluation methods of project funding.

5. Discuss the issues that are considered in project financing in India.

2.8 Answers

Answers to Self Assessment Questions

1. c

2. c

3. c

4. c

5. a

6. State government and their agencies

7. SPVs

8. a

9. a

10. b

11. a

12. a


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13. a

Answers to Terminal Questions

1. Refer section 2.1.

2. Refer Section 2.1.

3. Refer Section 2.1.1

4. Refer Section 2.4

5. Refer section 2.5

2.9 Case study

2.10 Glossary


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References

1. The Capital Budgeting Process by Shahid Ansari

2. Capital Budgeting: Theory and practise by Pamela P. Peterson, Frank J. Fabozzi

3. Finance for Engineers: Evaluation and Funding of Capital Projects by C.F.Crundwell.

4. Law 25/2005, of 24 November regulates Venture Capital Companies (ECR), Venture CapitalPartnerships (SCR), Venture Capital Funds (FCR).

[1] Refer The Capital Budgeting Process by Shahid Ansari

2 Refer Capital Budgeting: Theory and practise by Pamela P. Peterson, Frank J. Fabozzi

3 Refer the book Finance for Engineers: Evaluation and Funding of Capital Projects by

C.F.Crundwell

4 Refer Law 25/2005, of 24 November regulates Venture Capital Companies (ECR), VentureCapital Partnerships (SCR), Venture Capital Funds (FCR)

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National income concept repeat

7 NATIONAL INCOME

PART I : National Income Accounting

I. Concepts & Meaning of National Income

II. Measurement of National Income

III. Relevant Concepts of National Income

IV. Factors Affecting National Income

V. Uses of National Income Statistics

VI. Limitations of National Income

* * *

I. Concepts & Meaning of National Income

National income is a measure of the total flow of earnings of the factor-owners through theproduction of goods & services. In a simple way, it is the total amount of income earnedby the citizens of a nation.

All incomes are based on production. In this sense, national income reflects the level of

aggregate output.

The term national income carries at least 2 meaning in economics.

The total value of the level of aggregate output is called Gross National Product or G.N.P.
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G.N.P. is a measure of the total market value of all final goods & services currently

produced

by all the citizens of a nation within a period, usually a year.

There are a few points important here:

* It measures how much people produce.

* It counts current production only.

* It counts the level of output with a market value.

* It relies on the market prices of goods & services as a measure.

II. Measurement of National Income

There are mainly 3 approaches to measure GNP.

The relationship of the 3 approaches is shown by the diagram below.

The Circular Flow of Economic Activities

Expenditures ($) Product

Market

$

Output

Households Firms

Income by

production

$ Factor

Costs


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The 3 arrows in the diagram show the overall level of economic activities.

Based on these 3 directions of flows, i.e. a flow of income, a flow of output, & a flow of

expenditures, economists develop 3 approaches to measure GNP.

1. Output or Value-Added Approach

The total value of all final goods & services ( i.e. outputs ) can be found by adding up the

total values of outputs produced at different stages of production.

This method is to avoid the so-called double-counting or an over-estimation of GNP.

However, there are difficulties in the collection and calculation of data obtained. It is

from 1980 that the H.K. government started to collect data by this approach.

In 1995, the government started to release GNP data.

2. Expenditure Approach

The amount of expenditures refers to all those spending on currently-produced final goods& services only.

In an economy, there are 3 main agencies which buy goods & services. They are the

households, firms and the government.

In economics, we have the following terms:

C = Private Consumption Expenditure ( of all households )

I = Investment Expenditure ( of all firms)

G = Government Consumption Expenditure ( of the local government )

The expenditure approach is to measure the GNP. We could not buy all our outputs

because some are exported to overseas. Similarly, our consumption expenditures may

include the purchases of some imports. In order to find the GNP, the value of exports


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must be added to C, I & G whereas the value of imports must be deducted from the

above amount.

Finally, we have :

G N P at market prices = C + I + G + X - M

Gross Domestic Product ( GDP )

In HK, the government is difficult to know about the amount of income earned throughproduction by H K citizens outside H K and the income earned by foreign citizens withinHK because of free trade policy. So we can only find the amount of outputs producedwithin our domestic boundary.GDP is an aggregate measure of the total value of net output produced within the domesticboundary of an economy in a specific period, say a year.

Income from abroad = Income earned by local citizens ( H K ) from the provisionof

factor services abroadIncome to abroad = Income earned by foreign citizens from the

provision offactor services locally ( in H K )

Net income from abroad = Income earned from abroad - Income sent toabroad

G N P = G D P + Net Income from abroad

3. Income Approach

The income approach tries to measure the total flows of income earned by the factor-

owners in the provision of final goods & services in a current period.

There are 4 types of factors of production and 4 types of factor incomes accordingly.

National Income = Wages + Interest Income + Rental Income + Profit

The term profit can be further sub-divided into : Profit Tax ; Dividend to all those

shareholders ; & Retained Profit ( or retained earnings ).


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III. Relevant Concepts of National Income

Net National Product ( N N P )

The investment expenditure of the firms is made up of 2 parts. One part is to buy new

capital goods & machinery for production. It is called net investment because the

production capacity of the firms can be expanded.

Another part - consumption allowance or depreciation - is spent on replacing the used-up

capital goods or the maintenance of existing capital goods because capital goods will

wear and tear out over time..

Depreciation refers to all those expenses to replace physical capital due to wear and tear,

obsolscence, destruction and accidential loss etc.

The sum of these 2 amounts is called Gross Investment in economics.

Gross Investment = Net Investment + Depreciation

Net investment will increase the production capacity and output of a nation, but not by

depreciation expenditure. So we have,

N N P = G N P - Depreciation

G N P at factor cost

The amount of national income found by the income approach will not be the same as

the

amount of G N P at market prices found by the expenditure approach.

In the expenditure approach, the value of G N P includes some types of expenses whichare NOT factor incomes earned by the citizens. They include depreciation, indirect

business taxes, and government subsidies.

G N P at factor cost = GNP at market prices - Indirect Business Taxes + Subsidies

= GNP at market prices - Indirect Business Taxes less

subsidies


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GNP at factor cost carries the meaning that we are measuring the total output by their

costs of

production. As output generates income to the factor-owners, it is also related with thevalue

of national income.

G N P at factor cost = National Income + Depreciation

Depreciation is also a type of costs of production but will not become a source of income

directly. So, it is included in the factor cost but excluded in the value of national income.

Nominal G N P ( G N P at Current Market Prices )

GNP is a measure based on market prices which are expressed in terms of money. Inreality, market prices change all the time. The same amount of outputs may have differenttotal market values provided that prices change.

In order to isolate the effect of price changes on the value of GNP, economists have

developed the

concept and technique of constant market prices.

Example :

Nation A with a population of 5 million

1990 1995 2000

Price Quantity

(million)

Price Quantity

(million)

Price Quantity

(million)

T-shirt 1 6 1 6 2 6

Watch 2 4 2 6 2 5

Soft-drink 2 2 3 4 4 5


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G N P at the base year ( 1990 ) = 1 x 6 + 2 x 4 + 2 x 2 m. = 18 million

G N P at current market prices in 1995 = 1 x 6 + 2 x 6 + 3 x 4 m. = 30 million

G N P at current market prices in 2000 =

The 2 values of GNP at current market prices in 1995 & 2000 are calculated by using the

money prices in that year. They are also called nominal GNP.

Nominal growth rate of GNP refers to the change in the value of nominal GNP between

any 2 years, e.g. the nominal growth rate is 66.67 % between 1990 to 2000.

G N P at constant market prices of 1995 = 1 x 6 + 2 x 6 + 2 x 4 m. = 26 million

The real output changes from 18 to 26 million from 1990 to 1995. GNP at constant

market prices

is called real GNP.

The growth rate of real GNP is called real growth rate of GNP.

G N P at constant market prices in 2000 =

Real G N P

The value of real GNP is based on the prices of the base year. However, there are too

many different values of prices on goods & services. To make the calculation of GNP

easier, economists use a price index to find the real GNP.

A price index is a number showing the changes in the overall level of prices. It shows a

change in the general price level of an economy.

With the value of the price index, the real GNP of anyone year can by found:


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Real GNP = Nominal GNP X (Price index at base year / Price index at current year)

IV. Factors Affecting National Income

1. Factors of Production

Normally the more efficient and richer the resources, the higher the level of national

income

or GNP will be.

Land

Resources like coal, iron & timber are essential for heavy industries so that they must be

available and accessible. In other words, the geographical location of these natural

resources

affect the level of GNP.

Capital

Capital is greatly determined by investment. Investment in turn depends on other factors

like

profitability, political stability etc.

Labour & Entrepreneur

The quality or productivity of human resources is more important than quantity.

Manpower planning and education affect the productivity and production capacity of an

economy.

2. Technology

This factor is more important for nations with little natural resources. The development intechnology is affected by the level of invention and innovation on production.


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3. GovernmentGovernment can help to provide a favourable business environment for investment. Itprovides laws and order, regulations that affect exchanges. In HK, the government

promotesfree trade and competition which encourage economic activities.

4. Political StabilityA stable economic and political system helps the allocation of resources. Wars, strikes andsocial unrests will discourage investment and business activities.

V. Uses of National Income Statistics

Standard of LivingThe per capita GNP allows us to compare the standard of living of different nations. Ingeneral, a nation has a higher standard of living if its per capita GNP is greater than that ofanother nation.

Policy FormulationIn the compilation of GNP statistics, the government had already gathered a lot ofinformation of the economy. The government can base on these figures to plan and decideits policies.International ComparisonBy converting the local GNP figures into a common unit ( usually in US$ ), we cancompare the standard of living of different nations. It helps to show the rate of growth ordevelopment of different nations.Business DecisionThe GNP figures can show the level of development of different industries and sectors ofan economy. It helps the businessmen to plan for production.

VI. Limitations of National Income Statistics

GNP is a measure of the overall flow of goods & services, as well as to show the generalwelfare of the people.It aims not only at the level ofcost of living but also the standard of living. It is quitecorrect to show the cost of living but there are some limitations on the GNP statistics toindicate the standard of living of an economy.

1. Price ChangesA higher nominal GNP of a nation may not mean that the standard of living is better. If theprices increase at a high rate, the real GNP may even fall.

2. Omittion or Under-estimation

Voluntary ServicesGNP figures do not include the contribution of the voluntary agencies which raise thegeneral welfare, e.g. the Tung Wah group of hospitals.In this respect, the GNP figures under-estimate the level of welfare.


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The voluntary work of housewives is also neglected by the GNP figures. It again under-estimates our welfare or standard of living.

LeisureIt is also a source of welfare and raises our standard of living, e.g. the welfare enjoyed with

a Chinese New Year Holiday. However, the monetary value is difficult to calculate.

Illegal ActivitiesDrug trafficking and illegal gambling are activities omitted in the value of GNP. It isdifficult to determine its effect on the welfare of an economy.

Undesirable Effects of ProductionGNP figures had not considered the effects of pollution, traffic congestion on the economy.They have lowered our standard of living.

3. Problem of Comparison

Output CompositionNations with the same GNP may have different living standard because their outputcomposition may be different. In general, a higher level of consumer goods & services inthe GNP indicates a higher current level of living standard.

Distribution of Income & WealthIf income is obtained by a small rate of people in a nation, the general living standard isstill low compared with a nation having a more evenly distributed income or GNP.

4. Other Limitations

Population SizeA large population has a lower living standard even if its GNP is the same as that of asmall population. The per capita GNP is more useful to compare the 2 nations.

National DefenseIf a nation has spent a lot of resources in the production of weapons and so on, its livingstandardmay not be improved.

TimeTechnology will be improved over time. This may not be shown in GNP figures becausethere may be small changes in cost and price only.Besides, durable goods provide welfare to us over a period of time ( usually more than 1year ). This cannot be shown by GNP figures within a year.

Demand and supply analysis repeat2. DEMAND & SUPPLY ANALYSIS (I)


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I. Introduction: How is price determined?

II. Concept of Demand: Demand Schedule & Demand Curve;

Market Demand Curve; Law of Demand

III. Concept of Supply: Supply Schedule & Supply Curve;

Market Supply Curve; Law of Supply

IV. Concept of Market price: Equilibrium price & quantity; Excess

Demand & Excess Supply; Nominal & Relative Price

V. Change in Demand & Quantity Demanded: Movement & Shift;

Factors Affecting Demand

VI. Change in Supply & Quantity Supplied: Movement & Shift;

Factors Affecting Supply

VII. Changes in Demand & Supply

* * *

I. Introduction

In a market economy, individual consumers make plans of consumption and individual

firms make plans of production based on the changes in market prices.


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Economists use the term invisible hand to describe the frequent exchanges in the market

because everyone (no matter consumer or producer) takes the market price as a signal on trade

and makes exchanges with private property rights (defined and protected by laws).

The price system works in a market economy only if there is free choice within the market.

The following sections explain how the market price is determined by the interaction of

consumers (demand) and producers (supply).

In the latter parts, the factors causing a change in price are explained.

II. Concept of Demand

In economics, the word demand consists of 4 main concepts:

It refers to both the abilityto pay and a willingnessto buy by the consumer (s). Demand issometimes called effective demand.

Demand can be shown by a demand schedule which shows the maximum quantitydemanded (willing & able to buy) at all prices.

Demand is a flow concept. Our willingness and ability to buy is subjected to a timeperiod. At different times, we may have different demand schedules.

There are many factors affecting our demand. In order to explore the effect of price onquantity demanded, economists like to assume other factors unchanged so as to make

the

analysis easier.

In Latin, the term ceteris paribus means holding other factors constant or

unchanged.

* An individual demand refers to the quantity of a good a consumer is willing to buy and

able to buy at all prices within a period of time, ceteris paribus.

Demand Schedule & Demand Curve


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A demand schedule is a table showing the quantities of a good that a consumer would buy at alldifferent prices within a time period, ceteris paribus.In mathematics, price & quantity demanded have a functional relationship. (In a demand function,

price is called the independent variable and quantity demanded the dependent variable.)

A demand curve shows the above relationship in a graph.

The following example gives a demand schedule and a demand curve.

Label the X-axis & Y-axis first, then draw the curve.

A Demand Schedule for A Good of A Consumer

Price ($ per uint) Quantity Demanded

30 2

20 4

15 6

12 8

10 10

8 12

A Demand Curve for A Good of A Consumer (within a time period)

Price

30


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20

10

0 2 4 6 8 10 12 Quantity

The demand curve slopes downward from _____________ to ____________.

This slope implies that price and quantity demanded are inversely related, i.e. the lower the

price, the greater the quantity demanded, and vice versa, ceteris paribus.

Market Demand Curve

It refers to the demand for a good by all the consumers in the market, within a time period.

The following example gives a demand schedule in a market consisting of only 2 consumers, Tom &

Mary. Plot and name the market demand curve in the graph.

A Demand Schedule of A Market Consisted of only 2 Consumers

Price

($ per unit)

Quantity Demanded

Tom Mary Market (i.e. T + M)

30 2 1

20 4 3

15 6 5


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12 8 7

10 10 9

Demand Curve For Tom Demand Curve For Mary Market Demand Curve

30

20

10

0 2 4 6 8 10 1 3 5 7 9 5 10 15 20

The market demand curve is obtained by summing up the individual demand curves of the

good in the market. That is, at the same price, the total quantity demanded from all consumers

is added up and the value is plotted in the graph.

The technique used is called horizontal summation in economics.

Law of Demand

The market demand curve also slopes downwards from ____________ to ____________ .

The slope implies that price and quantity demanded are inversely related, ceteris paribus.

The relationship between prices and quantity demanded is called the law of demand in

economics.


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(Economics argue that they have observed the reality and found that people behave as describedabove according to the law. Such a common behaviour is believed to be a general phenomenon ofhuman behaviour. As a result, it is regarded as a law.)

III. Concept of Supply

The word supply bears 4 similar concepts with demand:

It refers to both the ability to sell (produce) and the willingness to sell by the producer(s).Supply implies an effective supply.

Supply can be shown by a supply schedule which shows the maximum quantity supplied at alldifferent prices.

Supply is also a flow concept. Time is an important factor affecting the condition of supply. There are again many factors affecting the supply of a firm. Economics hold the ceteris

paribus condition in order to analyze the relationship between price and quantity

supplied by a firm or producer.

* An individual supply ________________________________________________________

_________________________________________________________________________

Supply Schedule & Supply Curve

A supply schedule is a table showing the quantities of a good that a firm or producer would

produce (sell) at all different prices within a time period, ceteris paribus.

A supply curve shows the functional relationship between price & quantity supplied in a graph.

The following example gives a supply schedule and a supply curve of a firm.

A Supply Schedule for A Good of An Individual Firm

Price ($ per unit) Quantity Supplied

10 2


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18 4

28 6

40 8

50 10

A Supply Curve of A Good by A Firm

Price

50

40

30

20

10

0 2 4 6 8 10 12

The supply curve slopes upward from ______________ to _____________ .

The slope implies that the higher the price, the greater the quantity supplied, vice versa and ceteris

paribus.

Market Supply Curve

It refers to the supply for a good by all the producers or firms in the market, within a time

period.


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The example below gives a supply schedule in a market consisting of only 2 firms, B & N.

Plot & name the market supply curve in the graph.

A Supply Schedule Of A Market Consisted of Only 2 Firms

Price

($ per unit)

Quantity Supplied

N Market (i.e. B + N)

10 2 3

18 4 5

28 6 8

40 8 10

50 10 11

Like the case of market demand curve, the market supply curve is obtained by summing up the

individual supply curves in the market. The technique is also horizontal summation.

Supply Curve of B Supply Curve of N Market Supply Curve

50

30

10

0 2 4 6 8 10 3 5 7 9 11 5 10 15 20


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Law of Supply

The market supply curve slopes upward from ____________ to ____________ .

The higher the price, the greater the quantity supplied by a firm will be, ceteris paribus.This direct relationship between price and quantity supplied is called the law of supply.

IV. Concept of Market Price

With demand & supply in a market, the interaction between market demand & supply together

will determine the market price of a good.

Determination of Equilibrium Price & Quantity In A Market

The example below shows a schedule of market demand & supply for a good:

The Market Demand & Supply Schedule For A Good

Price ($ per unit) Quantity Demanded Quantity Supplied

60 200 1100

50 400 900

40 600 700

30 800 500

20 1000 300

10 1200 100

Plot the market demand & market supply curves in the graph.

Find out how the market price is determined as a result.


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The Demand & Supply Curves of A Good

60

50

40

30

20

10

0 200 400 600 800 1000 1200

Result:

From the market demand & supply curves above, it is found that there is a point at which the

quantity demanded is equal to the quantity supplied. The point is called an equilibrium point.

The price is called the equilibrium price which is about $_______________ .

The equilibrium quantity is at ________________ .

Everyone can buy what he/she wants in the market according to the market equilibrium price.

Producers or firms can sell what they produce.

The market is said to be in a state of __________________________ .

At the equilibrium price, quantity demanded is equal to quantity supplied. The quantitytransacted is an equilibrium quantity.

There is no tendency for the price to change at this equilibrium level of price. The meeting pointof the demand & supply curves is called the equilibrium point in the market.

Excess Demand & Excess Supply

Whenever the market price is above the equilibrium price, quantity supplied will be

_______________ than quantity demanded, there is a surplus in supply in the market, i.e. an excess

supply.

Whenever the market price is blow the equilibrium price, quantity demanded will be

_______________ than quantity _____________ , there is an excess demand in the market, i.e. a

shortage in supply.


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The example below gives a demand schedule and an increase in demand.

A Demand Schedule

Price ($/unit)Original Quantity Demanded

New Quantity Demanded

30 200 400

20 400 600

15 600 800

12 800 1000

10 1000 1200

8 1200 1400

A Demand Curve

30

20

10

0 400 800 1200

The new demand curve is at the ________ of the original demand curve, showing an increase in

quantity demanded at all prices.

It is called a shift of a demand curve to the right or and increase in demand.


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In case of a decrease in demand, the demand curve will shift to the _____________.

It is very important to distinguish between a change in quantity demanded (Qd) & a change indemand.

A change in quantity demanded (Qd) must be caused by a change in market price. A change in

demand is caused by someother factors other than a change in price.

Factors affecting a change in Demand : A

Shift of Demand Curve

1) Prices of Related Goods

When the price of a good (X) rises, it does not only affect its Qd, but also the Qd of another

related good (Y).

If a rise in price of good X leads to a in demand of good Y, these 2 goods are called

substitutes in economics. (There involves a movement along the demand curve of X and

a shift of the demand curve of Y.)

If a rise in price of good X leads to a fall in demand of good Y, these 2 goods are called

complements or complementary goods. They are in joint demand.

2) Income

A rise in income leads to a higher purchasing power or ability to buy of the consumers.( If nominal income and prices increase by the same percentage, the real income is

unchanged.)

If a rise in income leads to a rise in demand of a good by a consumer, the good is called a

normal good or superior good.

If a rise in income leads to a fall in demand of a good, the good is called an inferior

good. Inferior does not refer to the quality of the good.


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In general, a consumer will buy a basket of goods with some normal and inferior goods.

Do you agree?

3) Taste

It refers to the subjective choice of consumers. It may be affected by our knowledge, friends,education, culture and advertising.

4) Weather

We may demand different goods on different seasons or weather, e.g. umbrella, heater and evenfood.

5) Expectations of Future Price

Consumers would change their demand if they expect the future price changes.

6) Derived Demand

An increase in demand (e.g. for more university seats) of a good or service may also lead to a

demand for another good or service (e.g. for more lecturers, student hostels, and other

facilities). The demand for these related services is a derived demand from the university

seats.

7) Size of Population

A larger population would mean more consumers. The market demand curve would shiftto the right, i.e. an increase in quantity demand at all prices.

VI. Change In Supply & Quantity Supplied

The concepts here follow mainly that of demand.


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The Movement along A Supply Curve : Change in Quantity Supplied

Whenever the market price changes, a firm or supplier will change its quantity suppliedaccordingly. When the price rises, the quantity supplied will rise also. It is called a

movementalong the supply curve.

This movement

shows the response of a firm (in

case of an individual supply curve) or all

firms in the market ( in case of the market

supply curve) to a change in market price,

ceteris paribus.

The Shift of A Supply Curve : Change In Supply

A change in supply refers to a change of the whole supply schedule, i.e. the Qs changes at every

price. It may be an increase or decrease.

A Supply Schedule

Price Original Quantity Supplied New Quantity Supplied


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10

18

28

40

42

200

400

600

800

1000

400

600

800

1000

1200

A Supply Curve

40

30

20

10

0 400 800 1200

The new supply curve is at the ________ of the original supply curve, showing an increase in

quantity supplied at ALL prices.

It is an increase in supply with the supply curve shift to the ____________ .

The supply curve will shift to the ________ when there is a decrease in supply.

A change in quantity supplied is cause by a change in market price. A change in supply is cause bysome other factors besides a change in price.


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Factors affecting a change in Supply : A Shift of Supply Curve

1) Prices of Related GoodsWhen the price of a good (X) rises, it may lead to a decrease in supply of another good (Y). The 2

goods are in competitive supply, e.g. residential flats and commercial flats. When the prices of

residential properties rise, the developers will put more resources (e.g. cement, concrete etc.)

to build the flats. As a result, the supply of these building materials for commercial flats will

decrease.

When the price of a good (M) rise, it may lead to an increase in supply of another good (N). The

2 goods are in joint supply, e.g. beef and leather.

When the price of beef rises, more beef will be supplied. At the same time, more leather is also

available. A good which is a by-product of another good in general, is an example ofjoint supply.

2) Prices of Factors of ProductionA change in factor prices will change the cost of production. As a result, supply is affected. A fall

in factor prices would lower the production cost, leading to an increase in supply.

3) State of TechnologyAn improvement in technology would mean that a greater amount of output can be obtained

from a fixed amount of factors. The supply curve would shift to the right.

4) Objectives of Firms

A firm based on different objectives would act differently, i.e. profit maximization or sales

maximization.

5) Weather


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Weather usually affects agricultural products or construction works.

6) Expectation on Future Prices

7) Number of Producers or Suppliers

VII. Changes In Demand & Supply

In many cases, there are factors leading to BOTH a change in demand and a change in supply.

Whenever both demand & supply increase, the quantity transacted (quantity exchanged

between buyers & sellers) must be greater than before. The new equilibrium price is uncertain

because it depend on the magnitude of shift of the 2 curves.

The following diagrams may help to illustrate the effect of these changes on the market:


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Right now, you should be familiar with any changes in demand & supply in a market.

* * *

repeat managerial economics

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